Over the past two weeks, officials at the world’s most powerful and influential central bank have signaled a range of possible actions, from hiking rates again to “pausing” or “skipping” this round and resuming the tightening process in July. One Fed official has even hinted that it would have been better for the institution not to hike at its last meeting, in May.
We do not know where the Fed will land for two main reasons. It is a central bank that is excessively data-dependent in an unusually fluid economy; and it lacks a solid strategic foundation.
For this Fed, much will depend on the employment and inflation data that will be released in the days before the policy-setting Federal Open Market Committee (FOMC) meets. As matters stand (in late May), the data will probably lead them to hike rates again. That is not what I would do, given what I believe should be a more secular and strategic approach to monetary policy.
It is tempting to attribute the wide range of views among Fed officials to the fluidity of economic and financial conditions. After all, America’s debt-ceiling saga and banking-system tremors have further complicated an already uncertain outlook for growth and inflation worldwide.
But that explanation is too narrow, and it is unlikely to stand the test of time. The real reason that we have so much policy confusion is that the Fed is relying on an inappropriate policy framework and an outdated inflation target. Both of these problems have been compounded by a raft of errors (in analysis, forecasting, communication, policy measures, regulation, and supervision) over the past two years.
It is now widely agreed that the Fed dug itself a hole when it mishandled the critical initial responses to the return of inflation. Policymakers have been struggling to climb out ever since. Not only did the Fed mischaracterize inflation as “transitory” for most of 2021, despite mounting evidence to the contrary and warnings from prominent economists. It then responded too timidly after Fed Chair Jerome Powell acknowledged, in late November 2021, that “it’s probably a good time to retire that word [‘transitory’] and try to explain more clearly what we mean.”
These two missteps meant that the Fed would have to play massive catch-up, which it did by implementing the most concentrated set of rate hikes in decades. Such a big, sudden tightening generates greater risks to both growth and financial stability. Yet the catch-up process came too late to prevent inflationary pressures from migrating from the goods sector to services and wages. That crucial development has made core inflation (which excludes volatile food and energy prices) more stubborn and less sensitive to rate hikes, further increasing the risk of compounding policy errors.
This sequence also explains why Fed officials seem to be all over the map when it comes to forthcoming policy moves. Having missed a wide-open window for implementing the best possible response, they now find themselves in a quagmire of second-best policymaking, where every option implies a high risk of collateral damage and unintended consequences. Hike again in June, and you increase the risk of tipping the economy into recession and reigniting financial instability. Refrain from hiking, and you risk losing even more credibility (a problem compounded by the Fed’s excessive dependence on backward-looking data for policy moves that act with a lag).
I suspect that if the next round of labor-market and consumer-price data continues to surprise on the strong side, the Fed will announce another rate hike in June. But regardless of what it decides, its top priority now should be to use the next few months to address the structural weaknesses that led to this mess in the first place. That means not only overhauling its monetary-policy framework and internally assessing the suitability of its inflation target, but also addressing its institutional insularity, lack of cognitive diversity, and poor accountability.
